November 1, 2011
Dear Mr. Secretary:
Since the Committee last met in August, economic activity indicators have firmed and real GDP in the third quarter expanded at a 2.5% annual rate, a noticeable acceleration from the 0.8% growth rate experienced in the first half of the year. Real final sales reached a 3.6% growth pace in the third quarter, an even greater acceleration from its modest 0.8% growth pace in the first half. Economic activity has received support recently from a rebound in motor vehicle production and an easing in energy prices. Early indications suggest the economy continues to expand at a reasonable pace in the fourth quarter. Despite some progress recently, the ongoing debt crisis in Europe remains a downside risk to domestic economic activity. As was the case at the last meeting, the outlook for fiscal policy remains considerably uncertain, and expectations regarding budget deliberations continue to shape the outlook for next year.
The third quarter rebound in growth was driven by a pick-up in domestic final sales which accelerated to 3.2% annual growth rate, up from 1.3% the prior quarter, as both households and businesses quickened their pace of purchases. Net exports contributed 0.2%-point to growth last quarter, a surprisingly large gain, as imports expanded at only a 1.9% annual rate despite a large rebound in auto imports following earlier supply disruptions. Real inventory accumulation slowed markedly to only $5.4 billion at an annual rate last quarter subtracting 1.1%-point from real GDP growth. Industrial activity has been robust lately and the unexpected strength in third-quarter final sales and weakness in third-quarter inventory investment improves prospects for continued solid growth in the fourth quarter.
Consumer spending increased at a 2.4% pace last quarter, a firming from the anemic 0.7% growth rate the prior quarter. Real income edged lower in the third quarter, as prices rose faster than nominal income. Consumers managed to increase their pace of real spending by reducing the saving rate from 5.1% in the second quarter to 4.1% in the third quarter, and only 3.6% in September. Surveys measures of consumer attitudes remain at very depressed levels. So far, pessimism about the economy has manifested itself more in the housing market than in consumer spending. In addition to low sentiment, housing demand is likely being held back by difficulties in obtaining mortgage credit. Homebuilding has generally been subdued, though multi-family homebuilding is picking up as the shift from homeownership to renting drives rental vacancy rates down and puts upward pressure on rents.
Business fixed investment has remained the most reliably expansionary sector of the economy. Total outlays on capital expenditures rose at a 16.3% annual rate last quarter. Real spending on equipment and software increased at a 17.4% pace in 3Q11. Spending on information processing equipment and software slowed but spending on all other major categories of capital equipment accelerated sharply. Business spending on structures rose at a 13.3% annual rate, a step-down from the very robust pace seen in the second quarter, but nonetheless a solid outcome. Business fundamentals, such as excellent profitability, remain supportive of the outlook for capital spending. Survey indicators do suggest some moderation in the pace of business spending ahead, perhaps because levels of capital outlays have generally recovered much of the decline they experienced during the recession.
The September labor market report was an improvement from the upward-revised August report. In September 103,000 jobs were added, and on average 90,000 private sector jobs were created per month in August and September. Timely indicators such as jobless claims suggest positive job growth has continued into October. While overall employment has expanded, job growth has not been fast enough to make a meaningful dent in the unemployment rate, which stood at 9.1% in September, the same rate as in the prior two months. Wage gains remain modest, as average hourly earnings have increased just 1.9% over the past year.
Headline inflation remains somewhat firm, as the PCE price index rose 0.2% in September and is up at a 3.3% annual rate over the past three months. Looking forward, the easing in gas prices could cause this price index to dip slightly in October. Excluding food and energy, core inflation was expanding at a fast pace through much of the spring and summer, and on a year-ago basis the core PCE is up 1.6%. More recently, however, there is some evidence that the lapsing of commodity price pass-through as well as greater supply of motor vehicles is leading to an easing in core inflation, as the core PCE index was unchanged in September. Looking forward, the continued moderation in commodity prices should remove that upward source of pressure on headline and core inflation. Moreover, labor costs remain contained and inflation expectations are subdued, all of which should contribute to an easing in underlying inflation pressures.
Since the last meeting, monetary policy has been active in pursuing its full employment responsibility. At the August FOMC meeting, the Committee gave additional information on its interest rate guidance, indicating that conditions are unlikely to lead to an increase in overnight interest rates before mid-2013. At the September FOMC meeting, the Committee took action to extend the maturity of its portfolio of Treasury securities and also decided to reinvest the proceeds of maturing housing-related assets back into mortgage-backed securities. Collectively these actions have served to ease financial conditions somewhat.
Fiscal policy continues to remains in flux. The deficit “super committee” has less than a month to arrive at a plan that produces $1.5 trillion in deficit reductions over ten years. The progress of these deliberations is uncertain and market participants do not have high expectations for the outcome. Fiscal policy is set to tighten significantly early next year, though talks are ongoing regarding extending some income support measures that are scheduled to expire at the end of this year.
Against this economic backdrop, the Committee’s first charge was to examine what adjustments to debt issuance, if any, Treasury should make in consideration of its financing needs. The Committee did not feel any changes to coupon issuance were necessary at this time. There were ongoing discussions of the SFP (Supplementary Financing Program). Given the uncertainty surrounding the path and timing of future debt limit increases, the Committee continued to believe that the reintroduction of the SFP was not possible for the foreseeable future.
The Committee examined with more granularity the expected evolution of debt composition (attached). A familiar discussion on weighted average maturity ensued. The Committee continued to believe that more progress on maturity extension should be made, while being mindful of the cost effectiveness of the strategy. More work needs to be done in this regard.
The Committee also discussed the merits of adding floating rate notes to Treasury’s issuance program. While members were generally supportive, there were questions regarding the appropriate reference index, optimal maturities, and liquidity costs. Discussion on the topic was both exploratory and preliminary.
The second charge was to examine the impact of a prolonged period of low interest rates on financial markets. The presentation (attached) looks at the current rate structure’s impact on loan growth, bond asset managers, money market funds, foreign investors, bank portfolios, securities dealers, insurance companies, pension funds, mortgage lenders, and Treasury issuance mix. The paper probes each area for challenges, emerging changes, and opportunities posed by persistent low interest rates.
In the final charge, the Committee considered the composition of marketable financing for the remainder of the October 2011 to December 2011 quarter and the January 2012 to March 2012 quarter. The committee’s recommendations are attached.
Matthew E. Zames